Where Did the Emerging Market Crisis Come From?

Concerns of an impending emerging markets crisis have been a major worry for investors this summer. Crumbling confidence has seen foreign investment withdrawn from the likes of Turkey, Argentina, South Africa and India among others, all of which rely on money from foreign investors. The countries involved have suffered huge currency devaluations against the dollar, increasing the cost of their imports as well as their debt as borrowed dollars become more expensive to pay back. Furthermore, unemployment and inflation have remained high, while political instability compounds the situation, particularly in Argentina and Turkey as citizens see their savings evaporate.

Why did foreign investors like emerging markets? Although emerging market investments have always been perceived as risky, they do offer greater returns in compensation. These risks arise from poorer accounting standards and corporate regulation as well as weaker economic factors such as unemployment and inflation. In some cases, there may be political concerns such as corruption to add to investor worries. However, attitudes towards these risks changed suddenly in the past year, as the United States central bank (the Fed) has been gradually increasing US interest rates to prevent their strengthening economy from overheating. Higher interest rates make safe investments such as treasury bonds (backed by the US government) much more attractive. This lowers people’s appetite for risk and encourages the withdrawal of money invested in riskier emerging markets in favor of safer American investments.

Because of the increased demand for US investments, there is now an increase in demand (and thus value) for the US dollar while demand for other currencies continues to suffer. This has resulted in many emerging markets seeing the value of their currencies plunge. For example, the Turkish lira and the Argentine peso have been particularly affected, each frequently swapping places as the worst performing currency of the year.

However, why do devalued currencies matter? Essentially, poorly performing currencies add more complications as volatile currencies only add to investor worries and prompt them to sell. Foreign investors in these emerging markets (who convert the returns they get from their investments back into their own currency) see their yields fall in value.

Currency devaluations are bad news for governments and firms within emerging markets too, as borrowed dollars on overseas debt markets will be much harder to pay. According to Deutsche Bank, total foreign-currency denominated debt amounts to over 50% of GDP in Argentina, Turkey, and Hungary to name but a few, resulting in concerns from investors that emerging market firms and governments may be forced to default on their debts. However, confidence in emerging markets could be restored if the governments and central banks of these countries can propose and implement credible plans to recover from the downturn and repay debts. However, should money continue to flow out of emerging markets and governments and central banks are unable to devise an effective economic strategy, these countries may fall into an economic slump, leading to the deterioration of economic activity, similar to that seen a decade ago in the financial crisis.

Overall, the short-term future of these economies hinges on investors staying resolute in the face of uncertainty, as continued capital withdrawal could tip them into a crisis.

Daniel Farrington